CHAPTER 2Overview of Structured Funding

Never invest in a business you can't understand.

– Warren Buffet

FUNDING

Banks, building societies and non‐bank lenders are in the money business. Money, in all its forms, is for these institutions what inventories are for other businesses. As such, these institutions must raise money. A profitable institution will then loan the money out to borrowers at a higher average interest rate than the aggregate cost of its funding. The difference between these two rates is known as the net interest margin (NIM) and it is a key metric for all for‐profit financial institutions.

Banks need money for a multitude of reasons: for capital, liquidity and regulatory purposes. Interestingly enough, banks do not need to raise money to fund loans at inception. Alan Holmes, who managed the Federal Reserve System Open Market Account, wrote in 1969 that ‘in the real world banks extend credit, creating deposits in the process, and look for the reserves later’.1 Thus, in the process of writing loans banks are able to independently create money themselves in the form of deposits. In contrast, shadow banks require funding in order to be able to extend credit as they are unable to take deposits.

Whether or not the cash raised is used to fund loans, the term funding is still used ubiquitously in the financial services industry to describe the raising of money and will be used in this book as well.

All funding instruments have a cost to the issuer. The whole‐of‐life ...

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